Financial Management

Lecture 08

Example of du pontAssume you are given the following relationship for the Brauer Crporation.Sale / Total Asset = 1.5timesReturn On Equity ROE = 5%Return on Asset ROA = 3%Calculate Profit Margin and Debt Ratio,Solution :Return On Asset = Profit Margin x Asset Turn OverROA = PM x ATO.03 = PM x 1.5PM=.03/1.5 = 0.02ROE = PM x ATO x Equity MultiplierROE = PM x ATO x EM.05 = 0.02 x 1.5 x EM.05= 0.03 EMEM = .05 / 0.03EM =1.666Debt Ratio = 1- (1/Equity Multiplier)Debt Ratio=1- (1/1.667)Debt Ratio= 1-0.60Debt Ratio = 0.40 or 40%

– Comparative Ratios and “Benchmarking”

Benchmarking is the process of comparing a particular company with a group of “Benchmark” Companies.Many companies used benchmark companies, not only the same industry but top benchmark companies whether they

are in the same industry or not. Choosing a Benchmark• Benchmarking is to establish a standard to follow for comparison.• Some methods of benchmarking are:- Time-Trend analysis

- Peer Group Analysis Time-Trend Analysis • Based on the historical data of the firm - If the current ratio of a firm is 2.4 for the recent financial statements, we may compare it with the current ratios for last

10 years. - We may find that current ratio has declined over the years because of • More efficient usage of current assets • Change in the nature of business of the firm • Change in business practices of the firm Peer Group Analysis • Identifying the firms - competing in the same markets,

- Having similar assets, - Operate in similar ways

• Benchmarking: 1. Averages for this group of firms OR 2. the top firms among the group Problems with Financial Statements Analysis • No underlying theory to help identify the items or ratios to

look at or to guide in establishing benchmark • Very little help on value and risk - Which ratios matter the most? - What a high or low value might be? • Firms with many diversified businesses • Different accounting standards and procedures in different

parts of the world

Uses and Limitations of Ratio Analysis

Ratio are used by :– Managers, who employee ratios to help analyze, control, ad thus improve their operations.– Creditors analysts, to help them in ascertaining the payment ability of the firm.– Stock analysts who are interested in company’s efficiency and return, risk and growth prospect

of the firm for their investment.

• There are some potential problems associated with ratio analysis:If firm operates in different division and in different industry, for such company a

meaningful industry average is difficult to calculate.For better performance industry average doesn’t make sense to be achieved,

focus should be on industry leaders’ ratio.Inflation may badly effect business position and ratios.Seasonal factors can also distort a ratio.Windows dressing makes ratios stronger.\Inventory valuation and depreciation are accounting practices which affect

financial statements and ratios.It is difficult to generalize which ratio is good or bad.In one financial period some ratios seems good and some bad, if one ratio is to

be adjusted it would inversely affect other ratio.

Problems with ROE

Manager can not surely use ROE to maximize shareholder wealth.

» ROE does not consider risk.» Shareholder are not clearly sure on return,» ROE of two firms may same but size of business and

volume of transaction may different.» ROE does not consider amount of invested capital.

Looking Beyond the Numbers• The American Associate of individual investors (AAII) summarize some

factors for evaluating a company performance:• Are the company’s revenue tied to one key customer: If goes elsewhere• To what extend are the company’s revenues tied with one key product.

• Lack of diversification leads risk• To what extend company rely on singly supplier.

• Supplier may face shortage.• What percentage of the company’s business is generated overseas.

• Overseas sale may generate high profit and high growth.• Competition

• Competition leads to low price and low profit, the competence to be governed to face current and future competition

• Future prospect.

• Investment to be made in research and development to explore new product and new market.

• Legal and regularity environment.• Legal and regularity are key focal point for industry in forecasting

process.